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Budgets: why use it or lose it is harmful, reasons solutions

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The budgeting process and budgets themselves have significant impacts on management actions and performance, in both positive and negative ways. It is common at many local, state, or national governmental agencies, and nonprofit organizations, and even in some for-profit enterprises for managers to increase spending at the end of the budget cycle. This process, usually referred to as "use it or lose it" can be harmful to objectives of any organization. Managers do this, as they often feel that if they don't spend the amount that was budgeted this year, next year their supervisors will reduce their budget by the amount not spent in the current year. So, to avoid having their budget dollars reduced, managers often increase spending at the end of the year to ensure all budgeted amounts are spent even if items are not necessarily needed. This is more common in government and nonprofit organizations, but can be found in for-profit enterprises as well.

Requirement: Write a memo to the budget managers in an organization, assuming you are the CEO. Your memo should direct budget managers not to utilize this approach, but also offer a logical rationale, and perhaps an alternative solution.

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There are many reasons why padding the budget and spending everything by year end should not be a practice of our team. Here are the top six and my suggested practice to avoid the temptation:

1. IMA Ethics

We are committed to the IMA ethical code. That means that we communicate fairly, with all relevant information, and avoid actions that result in personal advantage. Spending just to be sure that your budget continues at a certain level is not ethical and violates the IMA ethical code. This lack of integrity about how resources are used will reduce your professionalism and hurt the firm. And, once it becomes apparent that you have this practice, your integrity in other matters will be suspect.

2. Tone at the Top

One of the best barriers to fraud in an organization is the tone-at-the-top. The teams looks at us. If we shade the truth for personal advantage, they will think this is acceptable. And so when they take the overruns or fail to report a situation, they will be doing as we do. So, by showing the team that we don't mind a ...

Solution Summary

Your discussion is 702 words and a reference and gives six reasons that this practice is harmful and a solution that solves this practice.

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Intermediate Economics

Download the simplest version of the model, FinanceministerBasic.exe.
Just click on the link (run the file rather than saving it) and it will prompt you to install the model to your PC. There is another version of this same model, FinanceministerDynaMo.exe. The only difference (which may be important from you view of matters) is that it graphs the variables all together in one chart and it lets you see more variables than the Basic model does. You might install and use it if you want to see a variable (like the government's budget deficit) that is hidden in the Basic version.

The economic relationships in the model are similar to models constructed by Hansen and Cooley, but lacks any money or a monetary sector. Prof. Uhlig has a rather technical pdf file (pdf-file) describing the model that uses mathematical methods well beyond the level of this course. Prof. Uhlig makes several basic points about the model:

"Following assumptions are made:

1. In the model households are assumed to be identical, that is, every household has the same preferences about leisure and consumption. Moreover, that means that all households can provide the same amounts of capital and labor.

2. In addition, all firms are identical: all jobs are equal, structural change does not occur, hence there is no possible unemployment due to missing/wrong qualification.

3. A closed economy is assumed: external trade and international flow of capital are neglected.

4. Moreover, fully flexible prices and perfect competition is assumed - thus, a perfectly functioning market economy where governmental regulation is not necessary to achieve the efficient solution.

5. Another simplifying assumption is considered in this context: in this model public spending does neither increase productivity nor is it required for purchasing public goods. Public spending, in terms of government purchases, are rather subsidies (e.g. for cultural institutions or security) which raise the households utility but are not productive. Child allowance or social benefits are denoted as »transfers« and are not included in public spending.

6. Evaluating political actions is done by considering the change in households' utility. This utility depends positively on private consumption and government purchases. However, higher labor input in this case impacts utility negatively as increasing employment here does not mean decreasing unemployment. Instead it signifies increasing working hours for the individual household in contrast to the usual perception." (These six points copied from Prof. Uhlig's site.)

There are several other assumptions or characteristics of the model we should bear in mind:

1) This model only shows you deviations away from a growth path similar to the one you saw in the Solow model. You never see the actual "default" growth path, just the deviation away from it.

2) There are two types of government expenditure in the model and three types of government revenues or taxation. The gov. pays interest on its debt to the private sector. The three types of taxation are:
first taxes on capital that is on capital's interest income. Higher taxes on capital reduce the incentive to invest in capital and reduces the capital stock. This will in turn lower the marginal productivity of labor and so reduce work effort.
second taxes on consumption. This stands in for ether sales taxes or VAT taxes.
third there is a wage tax. We might think of it as an income tax, but that would be somewhat misleading as it does not fall on interest payments or income from capital.

3) The government's budget constraint is very important in this model and has been handled in a way you wouldn't expect.

The default setting is for the government's budget to be balanced each year. The wage tax (or income tax) does not appear as a variable you can change. That is because the model changes the wage tax to balance the government's budget. The Gov Deficit to GDP ratio still moves around because the rate at which output grows will be affected by changes you make.

If you change the government budget balance parameter away from 1 towards 0 the model does not change the wage tax so much but instead lets the government run a deficit or surplus. It won't let you set this parameter to 0 because that would cause the GovDebt/GDP ratio to go to infinity which is not sustainable. While that is true one might like to see what happens if the economy temporarily follows a fiscal policy that is unsustainable in the future. Well you are not allowed to here.

I want you to get two things out of the model: first how does an increase in government spending affect growth in the long run and short run, and secondly which of the three taxes seems to be least damaging to growth?

Issue One: How does government spending affect the economy?
Increase government spending (say to around 936) while leaving the gov budget parameter that sometimes appears at the bottom of the screen at one.

Print the output and answer the following questions: How does an increase in government spending affect the economy? Looking at the assumptions of the model given above why is the effect of greater government spending different from what you would expect in a Keynesian model, such as the one you examined in Econ 106?

Issue Two: Which taxes hurt the economy the most.
There are three taxes in the model so if we think about raising one tax and increasing another tax to compensate then we have three parings to examine:
wage vs capital
wage vs consumption
consumption vs capital

Tax scenario one: Lower the tax on capital and let the program increase the tax on wages to keep the governments budget balanced. Does this seem to help or hurt consumption, output, employment? You can also do the opposite to check the results: increase the tax on capital letting the program decrease the tax on wages.
Tax scenario two: Lower the tax on consumption and let the program increase the tax on wages.

Does this seem to help or hurt consumption, output, employment? You can also do the opposite to check the results.

Tax scenario three: Lower the tax on capital to about 25% and increase the consumption tax to about 21%

Does this seem to help or hurt the economy?

Print the output for the scenario that seems to be most beneficial to the economy and answer the following question.

Which of the three taxes is least harmful to the economy and why?

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